Impact of market psychology on stock exchange performance

Have you come across cases where prices of shares decline and then rises with no underlying fundamentals supporting that movement – and you wonder, what was it all about? We recently have observed a similar situation in one of the listed companies. And today, our discussion will focus on how market psychology and market cycles affect market prices, read on:

Market Psychology

Market psychology is the overall sentiment or feeling that the market experiences at any time. Greed, fear, expectations, circumstances, etc are all factors that contribute to the market’s overall investing mentality or sentiment.

While financial theory describes situations in which all the players in the market behave rationally, such theory, however, do not account for the emotional aspect of the market that can sometimes lead to unexpected outcomes that can’t be predicted by simply looking at the fundamentals of the economy, or the underlying performance of the company, etc.

However, analysts normally use trends, patterns and other indicators to assess the market’s current psychological state in order to predict whether the market is heading in an upward or downward direction.

Market sentiment

Market sentiment refers to the psychology of market participants, individually and collectively.

It represents the general prevailing attitude of investors as to the anticipated price development in a market.

This attitude is the accumulation of a variety of fundamental and technical factors, including price history, economic reports, financial performance reports, seasonal factors, as well as national and world events.

Market sentiment is perhaps the most challenging category because as it is, it matters critically, but we are only beginning to understand it. Market sentiment is often subjective, biased, and obstinate.

For example, you can make a solid judgment about a share’s future growth prospects, and the future may even confirm your projections, but in the meantime the market may simply decide to dwell on a single piece of news that keeps the share artificially high or low. And you can sometimes wait a long time in the hope that other investors will notice the fundamentals.

Market sentiment is monitored with a variety of technical and statistical methods such as the number of advancing versus declining stocks and new highs versus new lows comparisons.

A large share of overall movement of an individual stock has been attributed to market sentiment.

In the last decade, investors are also known to measure market sentiment through the use of news analytics, which include sentiment analysis on textual stories about companies and sectors.

Emotions and perceptions

Share prices can change because of perceptions, greed, hype, momentum, fear, rumors, etc. Sometimes the stock market can be seen as the sum of the emotions of its human entrepreneurs, subject to the arbitrary human whims and flights of fancy.

According to a Wall Street saying, only two influences are at work on the stock market – “fear and greed”. Most of the time they are in equilibrium, with greed only staying dominant long enough to produce the long-term trend depicted on a share market graph.

The 1999 - 2000 technology boom was a good example of greed taking over. The Internet, and all that is connected with it, became the spice of the moment and the technology shares skyrocketed in price. But when it all got too much later in the year 2000 — some of us may recall what happened in the Nasdaq Stock Exchange.

Bullish & Bearish

This is the other side of hype and momentum of the market. If investors expect upward price movement in the stock market, the sentiment is said to be bullish.

On the contrary, if the market sentiment is bearish, most investors expect downward price movement. When a bear market sets in, fear takes share prices downward, to a long, bitter winter of discontent. During a recession nobody wants to buy shares. Only in hindsight do people realize that it was the best time to buy shares. This is what “value investors” the like of Warren Buffet operates and recommend. Himself being a student of Benjamin Graham, also commonly known as the father of value investing.

Seasons

“To everything there is a season, and a time to everything, and a season for every activity under heaven”, says the author of the Book of Ecclesiastes in the Bible. He could have been talking about the stock market as well!

Most stock markets show a distinct seasonal pattern. It has a regular seasonal correction at the end of the financial year.

This is normally followed by a major seasonal rally i.e. beginning of the tax year, periodical financial reporting seasons, etc.

The stock market is more likely to rise and fall in certain months than in others, i.e. portfolio or fund managers tend to withdraw from the markets at the end of each tax year to balance their holdings. They start spending again at the beginning of the subsequent tax year. Next week we would look on the impact of market cycles…